Negative gearing debate off track

The Reserve Bank is a cautious organisation and averse to fuelling speculation. So it is ironic that they have unintentionally ramped up speculation about negative gearing after releasing — under FOI laws — a 2014 internal memo mentioning that winding back negative gearing “may be a good thing” for financial stability.

However, the negative gearing abolitionists now trumpeting that the RBA is supporting a change would do well to look at it more closely.

The (heavily redacted) internal briefing note does not indicate the impact of a change on the tax system, the housing market or the overall economy. So we should view it narrowly — restricting negative gearing might make the financial system more stable; but at what cost to the rest of the economy? And the issue of stability is already being addressed with a recent tightening of prudential requirements for investor loans.

This leaves only the RBA’s stated downsides of changes to negative gearing: fire sales of negatively geared properties (which the ALP tries to address with grandfathering) and — more importantly for low income earners — the increases in rents. Clearly if rents are hiked, this will hit low income households harder, as they spend proportionally more on rent.

A range of other impacts are not addressed in the RBA memo: the most obvious being the impact on house prices and affordability. However, we can’t be confident that the ALP’s policy will result in a moderation of house prices, surely a goal of a policy to improve housing affordability.

For example, increased rents may encourage some renters to buy properties, increasing prices; similarly the ALP’s policy restricting negative gearing to new properties may increase the price of new dwellings. It isn’t clear that these prices increases will be offset by any reduction in the price of old properties.

The impact on investors is also important. The facile debate so far has been driven by the abolitionists carping about which income groups get the greatest share of the total benefits from gearing. But these discussions are a furphy. Almost all tax provisions provide a greater dollar benefit to the rich, including the GST exemptions for food, education and health.

The GST exemption for food provides a benefit to the top 10% of $631 per year and a benefit to the poorest 10% of $365. Yet no one is using this data to argue for the abolition of the GST exemption for food, because measuring dollar benefits to different income groups is the wrong approach.

Instead it is better to measure the benefits as a proportion of income: which is the way many other organisations (including our Parliamentary Budget Office and the US Congressional Budget Office) analyse the benefit of tax provisions. On this basis, the proportional benefits of the GST exemption are greater for low income groups, as we all expect.

Applying this same approach to negative gearing, we find that the largest percentage benefits of negative gearing actually go to the lowest decile of income earners in the tax system. This result can’t be dismissed as being tax avoidance by high income households: if a low income spouse is negatively gearing, then the household is actually paying more tax than if the higher income partner negatively geared.

Based on this data, the removal of negative gearing may hit lower income earners harder: renting is concentrated at lower income levels, as well as negative gearing itself. But these distributional issues should not be determinative. If the focus is always on distributional effects we wouldn’t ever make any policy changes if anyone rich — or foreign — benefited, regardless of the broader economic benefits. For example, the Treasury argues that company tax cuts will increase wages, employment, investment and GDP, but a central argument used against these cuts are that they benefit foreign investors.

So if decisions about negative gearing should not hinge on financial stability and distributional impacts, what should the emphasis be on? A greater focus should be on how a change would affect the tax system; and on this basis, caution should abound.

Playing with negative gearing would (further) interfere with a fundamental part of the tax system: costs should be deductible against income. There are already some tweaks to this rule; and the more tweaks that are made, the more complex the system will become and the greater the incentives for tax avoidance.

But more importantly, the tax system will become further biased against risk taking. If you can’t deduct losses, then the incentives to invest in riskier assets and enterprises will be reduced — a poor result for what should be an innovative economy.

Negatively gearing is closely tied to capital gains tax (CGT), a point noted in the RBA memo. Negative gearing has always been around, but greatly increased after the 1999 changes to CGT. So instead of playing with the fundamental principle of deductibility of losses, a better option would be to return to the CGT system before 1999 (which involved indexation and an averaging provision that avoided overtaxation of one-off large capital gains), with an additional discount.

This discount should be set so that the tax burden on capital remains lower than the burden on other income, in alignment with the views of many tax experts.

This would be a much better approach than the proposals to slash the CGT discount and not reintroduce indexation, which will result in most capital gains being slapped with a higher tax rate than other income  — the opposite of the tax rate that should apply to capital.

It is unfortunate that the negative gearing debate has gone far off this track. There have been proposals for a supertax being applied to capital, when most experts agree this tax rate should be lower. We are debating the impact on financial stability, when this issue has already been largely addressed. We are using the wrong measures of distributional impact, and we are basing policy discussions over who wins and loses rather than the overall economic impact. Policy discussion deserves better.

Michael Potter is a Research Fellow in the Economics Program at the Centre for Independent Studies